How Might The Expected Future Reappearance Of Higher Tax Rates On Individuals Receiving Dividends Affect Corporate Dividend Payout

Dividend Fundamentals retained earnings Earnings not distributed to owners as dividends; a form of internal financing.

Expected cash dividends are the key return variable from which owners and investors determine share value. They represent a source of cash flow to stockholders and provide information about the firm's current and future performance. Because retained earnings, earnings not distributed to owners as dividends, are a form of internal financing, the dividend decision can significantly affect the firm's external financing requirements. In other words, if the firm needs financing, the larger the cash dividend paid, the greater the amount of financing it must raise externally through borrowing or through the sale of common or preferred stock. (Remember that although dividends are charged to retained earnings, they are actually paid out of cash.) The first thing to know about cash dividends is the procedures for paying them.

Cash Dividend Payment Procedures

At quarterly or semiannual meetings, a firm's board of directors decides whether and in what amount to pay cash dividends to corporate stockholders. The past period's financial performance and future outlook, as well as recent dividends paid, are key inputs to the dividend decision. The payment date of the cash dividend, if one is declared, must also be established.

Amount of Dividends

Whether dividends should be paid, and if so, in what amount, are important decisions that depend primarily on the firm's dividend policy. Most firms have a set policy with respect to the periodic dividend, but the firm's directors can change this amount, largely on the basis of significant increases or decreases in earnings.

date of record (dividends) Set by the firm's directors, the date on which all persons whose names are recorded as stockholders receive a declared dividend at a specified future time.

ex dividend

Period, beginning 2 business days prior to the date of record, during which a stock is sold without the right to receive the current dividend.

payment date

Set by the firm's directors, the actual date on which the firm mails the dividend payment to the holders of record.

Relevant Dates

If the directors of the firm declare a dividend, they also typically issue a statement indicating the dividend decision, the record date, and the payment date. This statement is generally quoted in the Wall Street Journal and other financial news media.

Record Date All persons whose names are recorded as stockholders on the date of record set by the directors receive a declared dividend at a specified future time. These stockholders are often referred to as holders of record.

Because of the time needed to make bookkeeping entries when a stock is traded, the stock begins selling ex dividend 2 business days prior to the date of record. Purchasers of a stock selling ex dividend do not receive the current dividend. A simple way to determine the first day on which the stock sells ex dividend is to subtract 2 days from the date of record; if a weekend intervenes, subtract 4 days. Ignoring general market fluctuations, the stock's price is expected to drop by the amount of the declared dividend on the ex dividend date.

Payment Date The payment date, also set by the directors, is the actual date on which the firm mails die dividend payment to the holders of record. It is generally a few weeks after the record date. An example will clarify the various dates and the accounting effects.

Example

At the quarterly dividend meeting of Rudolf Company, a distributor of office products, held on June 10, the directors declared an $0.80-per-share cash dividend for holders of record on Friday, July 2. The firm had 100,000 shares of common stock outstanding. The payment date for the dividend was Monday, August 2. Figure 13.1 shows a time line depicting the key dates relative to the Rudolf Company's dividend. Before the dividend was declared, the key accounts of the firm were as follows:

Cash $200,000

Dividends payable Retained earnings i 0 1,000,000

When the dividend was announced by the directors, $80,000 of the retained earnings ($0.80 per share X 100,000 shares) was transferred to the dividends payable account. The key accounts thus became

Cash $200,000

Dividends payable Retained earnings

Rudolf Company's stock began selling ex dividend 2 business days prior to the date of record, which was Wednesday, June 30. This date was found by subtracting 2 days from the July 2 date of record. Purchasers of Rudolf's stock on Tuesday, June 29 or earlier received the rights to the dividends; those who purchased the stock on or after June.30 did not. Assuming a stable market, Rudolfs stock price was expected to drop by approximately $0.80 per share when it began selling ex dividend on June 30. On August 2 the firm mailed dividend checks to the holders of record as of July 2. This produced the following balances in the key accounts of the firm:

Cash $120,000

Dividends payable $ 0 Retained earnings 920,000

The net effect of declaring and paying the dividend was to reduce the firm's total assets (and stockholders' equity) by $80,000.

Dividend Payment Time Line

Time line for the announcement and payment of a cash dividend for Rudolf Company

Declaration Date

Thursday, June 10

Ex Dividend Date

Date of Record i

Board of directors declares $0.80 per share dividend, payable to holders of record on Friday, July 2, payable on Monday, August 2.

Wednesday, Friday, June 30 July 2

Stock begins to sell ex dividend on Wednesday, June 30, which is 2 business days before the Friday, July 2, date of record.

Payment Date

Monday, August 2

Checks of $0.80 per share are mailed on Monday, August 2, to all holders of record on Friday, July 2.

Tax Treatment of Dividends

The Jobs and Growth Tax Relief Reconciliation Act of2003 significantly changed the tax treatment of corporate dividends for most taxpayers. Prior to passage of the 2003 law, dividends received by investors were taxed as ordinary income at rates as high as 35 percent. The 2003 act reduced the tax rate on corporate dividends for most taxpayers to the tax rate applicable to capital gains, which is a maximum rate of 5 percent to 15 percent, depending on the taxpayer's tax bracket. This change significantly diminishes the degree of "double taxation" of dividends, which results when the corporation is first taxed on its income and then when the investor who receives the dividend is also taxed on it. After-tax cash flow to dividend recipients is much greater at the lower applicable tax rate; the result is noticeably higher dividend payouts by corporations today than prior to passage of the 2003 legislation. (For more details on the impact of the 2003 act, see the Focus on Practice box below.)

(Focus on Practice}

Capital Gains and Dividend Tax Treatment Extended to 2010

In 1980, the percentage of firms paying monthly, quarterly, semiannual, or annua! dividends stood at 60 percent By the end of 2002, this percentage had declined to 20 percent in May 2003, President George W. Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of2003 (JGTRRA). Prior to that new law, dividends were taxed once as part of corporate earnings, and again as the personal income of the investor, in both cases with a potential top rate of 35 percent The result was an effective tax rate of 57.75 percent on some dividends. Though the 2003 tax law did not completely eliminate the double taxation of dividends, it reduced tine maximum possible effect of the double taxation of dividends to 44.75 percent For taxpayers in the lower tax brackets, the combined effect was a maximum of 33.25 percent

Both the number of companies paying dividends and the amount of dividends spiked following the lowering of tax rates on dividends. S&P 500 dividends rose at an 11 percent compound annual rate from 2002 to 2005, a major increase over the prior 10 years when dividends grew at only a 2 percent annual pace, according to Goldman Sachs.

The tax rates under JGTRRA were originally programmed to expire at the end of 2008. However, in May 2006, Congress passed the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), extending the beneficial tax rates for 2 more years. Taxpayers in tax brackets above 15 percent pay a 15 percent rate on dividends paid before December 31, 2008. For taxpayers with a marginal tax rate of 15 percent or lower, the dividend tax rate is 5 percent until December 31, 2007, and 0 percent from 2008 to 2010. Long-term capital gains tax rates were reduced to the same rates as the new dividend tax rates through 2010. Pre-JGTRRA taxation of dividends reappears in 2011, unless further legislation makes the law permanent The reduction of the tax burden on dividends has two potential benefits. First, the equalization of the tax treatment of dividends and capital gains allows corporations to base their payout policies on the economic value of a decision, not the tax consequences. And second, if corporations increase their dividend payouts, tower cash reserves will force managers to undertake only the most pro ductive internal investments. In addition, the regular payment of quarterly dividends can be paid only out of earnings or cash reserves that actually exist, which promotes honest accounting practices.

B How might the expected future reappearance of higher tax rates on individuals receiving dividends affect corporate dividend payout policies?

( Personal Finance Example The hn3rd of Hirerrnr. of Fspinnra Industries, Tnr., nn Ortnher 4 nf rh* current year, declared a quarterly dividend of $0.46 per share payable to all holders of record on Friday, October 30. They set a payment date of November 19. Rob and Kate Heckman, who purchased 500 shares of Espinoza's common stock on Thursday, October 15, wish to determine whether they will receive the recently declared dividend and, if so, when and how much they would net after taxes from the dividend given that the dividends would be subject to a 15% federal income tax.

Given the Friday, October 30, date of record, the stock would begin selling ex dividend 2 business days earlier on Wednesday, October 28. Purchasers of the stock on or before Tuesday, October 27, would receive the right to the dividend. Because the Heckmans purchased the stock on October 15, they would be eligible to receive the dividend of $0.46 per share. Thus, the Heckmans will receive $230 in dividends {$0.46 per share X 500 shares), which will be mailed to them on che November 19 payment date. Because they are subject to a 15% federal income tax on the dividends, the Heckmans will net $195.50 [(1-0.15) X $230] after taxes from the Espinoza Industries dividend.

Dividend Reinvestment Plans dividend reinvestment plans (DRIPs)

Plans that enable stockholders to use dividends received on the firm's stock to acquire additional shares-even fractional shares—at little or no transaction cost

Today many firms offer dividend reinvestment plans (DRIPs), which enable stockholders to use dividends received on the firm's stock to acquire additional shares—even fractional shares—at little or no transaction cost. Some companies even allow investors to make their initial purchases of the firm's stock directly from the company without going through a broker. With DRIPs, plan participants typically can acquire shares at about 5 percent below the prevailing market price. From its point of view, the firm can issue new shares to participants more economically, avoiding the underpricing and flotation costs that would accompany the public sale of new shares. Clearly, the existence of a DRIP may enhance the market appeal of a firm's shares.

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